Congress to the Rescue?

Congress to the Rescue?

More and more mortgage borrowers can’t keep up with their monthly house payments, and Congress wants to rescue them. “I’m determined to do everything we can to allow people to stay in their homes,” Democratic senator Chris Dodd, head of the banking committee, said on Wednesday. But congressional meddling is not the way out of subprime-mortgage woes; in fact, government action will prolong the crisis.

Nearly 5 percent of mortgage borrowers were past due on their loans during the final three months of 2006, up about 6 percent from the third quarter, according to the Mortgage Bankers Association. But in the “subprime” mortgage market—mortgages awarded to people with high debt, bad credit, or spotty work histories—delinquencies were at more than 13 percent, also up 6 percent from the previous quarter. And nearly 8 percent of those loans were in foreclosure or in danger of foreclosure—that is, the lenders could repossess the homes.

Historically, mortgage delinquency rates rise when the economy is bad and unemployment is high, but this time it’s different. Over the past half-decade, lenders and home buyers alike dived into mortgages because they expected prices in the nation’s torrid housing markets to keep rising at unsustainable rates; indeed, between 2000 and 2006, resale prices of existing homes more than doubled in ten of the nation’s biggest regions, including its major commuting corridors, after having risen only 60 percent in the 13 years between 1987 and 1999, according to the Case-Shiller Home Price Indices report. But over the past year, prices have generally stayed flat or declined. Unsustainable price increases in most markets have stopped, as all unsustainable things eventually do.

It may not seem like such a big deal that real-estate prices have flattened. But the problem is that millions of Americans borrowed homes because they, and their lenders, expected the prices to keep rising. (It’s hard to say that these Americans bought their homes, since in many cases they own nothing but the furniture inside.) In fact, they couldn’t have afforded their homes if not for rising prices.

Say, for example, that two years ago you wanted to “buy” a home outside Phoenix, where prices had already more than doubled since 2000. But you had hardly any money to put down and didn’t make enough money to afford a 30-year, fixed-rate mortgage. No problem: the lender would lend you 95 or even 100 percent of the price, and offer you a special introductory interest rate that would “reset” to a much higher rate in a couple of years. And even if you couldn’t afford the low introductory mortgage every month, some lenders would let you just roll over the balance, adding to your mortgage debt rather than subtracting from it.

This type of loan only makes sense when prices keep rising—because the idea was that every few years you could refinance your house, using the extra money from the house’s higher value to pay down some of the mortgage. But that scheme doesn’t work when home-price increases screech to a halt; today, in fact, some borrowers owe more on their mortgages than their homes are worth.

Senator Dodd hasn’t quite worked out the details of the legislation that he’ll propose to bail out these troubled borrowers. But there’s good reason to suspect that it will involve Fannie Mae and Freddie Mac, the nation’s biggest mortgage companies. Fannie and Freddie are nominally in the private sector, but they operate under a congressional charter to make a market for low-income and middle-class home buyers, largely by purchasing mortgages from banks so that the banks have more money to make new mortgages. According to the Wall Street Journal, HUD secretary Alphonso Jackson said Wednesday that he had asked Fannie and Freddie “to look into possible steps that could be taken to assist troubled borrowers.” It’s conceivable that Dodd, with the Bush administration’s support, will propose some sort of government subsidy for the two companies to buy out some defaulted mortgages from their private investors, taking over the loans and refinancing their terms with borrowers so that borrowers can stay in their homes.

Sounds harmless enough, right? But it would create a huge problem. Investors in mortgage loans, including investment banks, pension funds, and international bondholders, jumped into risky subprime mortgages because they were paid for that risk, getting higher interest rates than they would have received for investing in, say, Treasury bonds. The reason that the risky mortgages paid more, of course, was that there was a very real possibility that lots of borrowers would default.

If the government, or its proxy, now steps in and purchases those mortgages, or otherwise systematically bails out borrowers, it will create a hazard for the future. The next generation of mortgage lenders won’t take the high risk of subprime home loans seriously, because they’ll expect that, in the event of another crisis, the government will step in and bail them out again. So they’ll be even more eager to approve the risky subprime mortgages that are getting so many borrowers into trouble in the first place.

And what about all those afflicted borrowers? It’s a harsh but unavoidable truth that many of them are in trouble now because they borrowed overpriced houses that were way beyond their means. If a family didn’t do the hard work of saving for a down payment and buying a house on which it could afford to pay a normal 30-year mortgage, it’s unfair for the government to bail it out—and its lender. Remember who would subsidize that bailout through federal taxes: the family down the street that rented for a few years while it saved up money, or that bought a smaller, older house within its means.

As real-estate prices float back down to reality, more people will be able to afford houses the old-fashioned way anyway. When borrowers default, banks will sell their houses at dramatically lower prices. And more vacant homes also mean lower rents for families who can’t afford to buy. Government intervention will retard this healthy process.

Some mortgage lenders and brokers allegedly forged documents, lied to potential borrowers, or otherwise sold home borrowers a bill of goods, and of course the government should prosecute those who committed fraud. But deeper government intrusion—though it may seem a sensible way to help those in need—would be a mistake.